Does Breaking Up Darden Restaurants Make Sense?

Darden Restaurants (NYSE: DRI  )  is one of the major players in the restaurant industry. The company operates the mature Olive Garden and Red Lobster brands, as well as smaller brands such as LongHorn Steakhouse, Yard House, and Bahama Breeze. Activist investor Barington Capital Group has recently suggested that the company should break itself up, taking issue with the dormant stock price. Does a breakup make sense for Darden investors?

The possibilities
Barington suggests splitting up Darden into two new companies: The first would be comprised of Olive Garden and Red Lobster, both mature and profitable brands. The second would then be comprised of all of the smaller brands, which have greater growth prospects.

Olive Garden and Red Lobster have been struggling lately. Last quarter, the company announced about $50 million in annual cost cuts in an effort to boost earnings amid falling same-store sales. The smaller brands are doing better -- LongHorn posted 3.2% same-store sales growth and 14.2% total sales growth last quarter as 47 new stores were built in the past year. Capital Grille grew same-store sales by 3.2%, Bahama Breeze by 2.7%, and Eddie V's by 2.1%.

The reasoning behind the proposed breakup is simple. The company with mature brands can boost its dividend or buyback effort, since capital expenditures will be limited mainly to maintenance. The other company can expand aggressively, and if successful, can command a fairly high valuation from the stock market. The goal is for the sum of the parts to be worth more than the company as it stands today.

One unique aspect of Darden is that the company has a significant real estate portfolio. Darden owns both the land and the buildings at about 1,000 locations, and it owns the buildings at another 800 locations. Barington estimates the value of this real estate at $4.4 billion. This presents two possibilities.

The first is to sell off the real estate and lease it back. This would give the company a pile of cash to initiate a huge buyback, or pay off debt, and shareholders would likely benefit from capital appreciation.

A second possibility is rolling the real estate into a REIT. This would allow Darden to reduce its tax burden by paying rent to the REIT, which would then be able to distribute its earnings without paying taxes on them. The result would be more cash going back to shareholders. I can't comment on the feasibility of this option -- I'm no REIT expert -- but it's an interesting idea.

One concern with any sort of spinoff would be that the smaller brands wouldn't have enough capital to expand quickly enough. Currently, profits from the mature brands can be used to grow the smaller brands. A breakup is no good if the resulting high-growth company can't grow.

A similar strategy
A company which has done something similar to what Barington is proposing is Brinker International (NYSE: EAT  ) . Brinker currently operates the Chili's brand and the Maggiano's Little Italy brand, but over the past decade the company has sold off other brands in order to narrow its focus.

In 2005 the company sold off the Corner Bakery Cafe, then in 2008 it sold a majority stake of Romano's Macaroni Grill. It then sold On The Border Mexican Grill in 2010, leaving the company with just two remaining brands.

This strategy has allowed Brinker to buy back a tremendous number of shares. Over the past three years, the company has spent about $1 billion on buybacks, boosting per-share numbers significantly. While the net income has grown by 15.6% since fiscal 2011, earnings per share have jumped by 43.7% during the same time. The stock has surged, leaving Darden in the dust.

EAT Chart

Brinker data by YCharts.

Small chains getting rich valuations
Besides Olive Garden and Red Lobster, LongHorn Steakhouse is the largest chain operated by Darden. LongHorn had 438 locations as of the end of the last quarter, compared to 704 Red Lobster locations and 832 Olive Garden locations. All other concepts have locations numbering in the dozens, making LongHorn the only proven smaller brand.

Independent steakhouses, like Texas Roadhouse (NASDAQ: TXRH  ) , currently trade at premium valuations. Shares of Texas Roadhouse sell at about 27 times last year's earnings, compared to 16 for Darden as a whole. Texas Roadhouse is about the same size as LongHorn, with around 400 locations, and it has a market capitalization of just about $2 billion.

LongHorn Steakhouse represents 20% of Darden's store count, but if valued at $2 billion like Texas Roadhouse would make up about 30% of the total market cap. With LongHorn showing strong same-store sales growth, it might make sense to spin off just LongHorn, leaving the smaller concepts with Darden.

The bottom line
A spinoff of just LongHorn Steakhouse seems like the best option to me. LongHorn is large enough that it can fund its own expansion, and the high multiples it could command would lead to a net increase in value for current Darden shareholders. The smaller concepts should stay with Darden, as profits from the mature brands can fuel expansion and an eventual spinoff of those brands in the future. I think Barington has the right idea, and we'll have to wait and see if Darden listens. 

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